| Big
GAAP, Little GAAP
OCTOBER
2006 - I read with interest the article and the viewpoint
on Big GAAP versus Little GAAP in the May and August 2006
issues. I agree with author Neville Grusd (“On Big GAAP
Versus Little GAAP,” August) on the feasibility of simply
taking a qualified opinion for any exceptions to GAAP found
in the private company’s accounting that were due simply
to the impracticality of the rule rather than to malfeasance.
Furthermore, experiences of the past few months have made
clear to me that a real standards-setting problem has not
been addressed: The change in the basis for accounting from
historical cost to fair value will cause an unnecessary problem
for private companies. In
April, I participated in two conferences, one concerning
fair-value accounting, the other pension accounting. In
the first conference, I shared the dais with Ed Trott of
FASB. In the second conference, Peter Prostakes, the pension
project manager for FASB, was also on the program. In the
first conference, I asked Ed Trott if FASB did not believe
it had any responsibility for the wide range of fair values
allowed under such standards as SFAS 133 (for derivatives),
which permitted Enron to extensively manipulate earnings.
He clearly responded that FASB did not have any responsibility
regarding the application of their standards. This position
was reiterated a few days later by Peter Prostakes.
I was
taken aback by their position. Throughout my career—private,
public, and teaching—I have believed regulators were
supposed to help private accountants and public accountants
to make rules that aid comparability but also that help
to control fraud. Certainly the SEC was formed with those
goals in mind. The abuses of the 1920s, such as writing
up assets and watering stock, or paying dividends from capital,
had to be stopped. Throughout the history of the regulators—the
SEC, the CAP, and the APB—those goals remained. The
change began with the Trueblood report, which resulted in
the conceptual framework. No specific reference was ever
made (that I can find) that the very basis of accounting
data was going to be changed from historical cost to fair
value. In fact, in the early days of the conceptual framework,
this fear was ridiculed. However, the shift has been happening
for the past 20 years and has resulted in a subtle loosening
of the control function of accounting standards.
The
position stated by Trott and Prostakes would be correct
if the standards were based on historical cost, as they
had been for more than 50 years. Although accrual accounting
has a built-in subjectivity, the basis did not change. This
is not true under fair value; under fair value there is
no starting point that is as clear as historical cost.
What
has actually happened over the past 20 years or so is that
the emphasis of financial reporting (as determined by FASB)
has shifted from the elimination of alternative accounting
methods and control of fraud in the day-to-day operations
of a business to an economic view of "values"
for use by the stock market in evaluating investments without
regard to managements' need for a control system for the
company's normal operations. The result has been such standards
as SFAS 133 (derivatives), SFAS 142 (goodwill, which allows
the amortization to be whatever you want it to be), SFAS
144 (impairment of long-lived assets), and the most-recent
proposal covering fair-value measurement, none of which
are needed to run the day-to-day operations or that provide
data for measuring the performance of employees that provide
needed internal control of operations.
While
the debate concerning fair value may continue with regard
to public companies, it is not relevant to private companies.
If I owned a company alone (or even with a few partners)
I wouldn’t restate my securities every quarter under
SFAS 133. As the owner I would evaluate my risks, of course,
but I would not befoul the control system with the analyses.
If I thought I wanted an audit, I would take the qualification
from the fair value of GAAP.
Eugene
H. Flegm, CPA, CFE
Bonita Springs, Fla.
The
writer was the general auditor for General Motors Corp.
before his retirement. His article “Accounting at
a Crossroad: Preserving an Independent Profession”
(The CPA Journal, December 2005) won the Journal’s
2005 Max Block Distinguished Article Award for the Best
Article in the Area of Policy Analysis.
Regarding
‘Assessing Materiality: A New “Fuzzy Logic”
Approach’
In
“Assessing Materiality: A New ‘Fuzzy Logic’
Approach” (June 2006), the article’s introductory
explanation to fuzzy logic was informative; however, some
ideas with respect to auditing standards and their applicability
should be clarified. The authors indicate that “in
practice, an auditor must make an oversimplified binary
decision” about materiality.
Professional
standards and practice dictate that both qualitative and
quantitative considerations be included in assessing whether
a misstatement is material. At times, this might appear
as a bypassed opportunity for auditors to incorporate qualitative
analysis in their assessment of materiality. In practice,
however, this process is often utilized. Accordingly, it
is not clear on what basis the authors indicate, “Auditors
tend to view materiality as a quantitative concept.”
Is there cited research to support this statement?
Seasoned
auditors would know that material misstatements and possible
misstatements should be taken as a whole. At the conclusion
of their audit, auditors are required by professional standards
to assess the possible materiality of the aggregate of possible
misstatements. Accordingly, if several possible misstatements
are below the materiality threshold their aggregate may
still be considered a material misstatement.
The
use of fuzzy logic is appropriate in many situations. The
application of fuzzy logic changes the questions from, “Is
it material?” (the answer can be “yes”
or “no”) to, “How material is it?”
(the answer can range from 0% to 100%). However, this format
has limitations. Specifically, our legal system may not
be positioned to accept a level of ambiguity about such
matters. The question of materiality is important to auditors,
who put their name out to the public to attest that the
users of financial statement may rely on the assertions
in the statement in all material respects. In legal terms,
the reliance on materiality is fundamental to the degree
of responsibility auditors may take on their attestation.
Modifying the definition of materiality could have grave
consequences to auditors if it does not stand in court.
Finally,
the construction of fuzzy-logic expert systems is well understood.
However, expert systems are often used in homogeneous situations.
Fuzzy-logic expert systems work best with events that tend
to repeat within a certain domain of results. In these domains,
expert systems can be constructed around repeated trends
and understanding of the domain of possible outcomes. However,
financial statements and audits are anything but a domain
of limited outcomes; each engagement and each financial
statement has unique and dynamic characteristics and challenges.
Expert systems will be hard pressed to accommodate each
and every audit engagement with its unique environment,
period-to-period adjustable variables, and new variables.
Although in theory this can be accomplished, I am afraid
the cost would be substantial on a per-engagement basis.
Coupled with the possibly weakened legal position, this
approach may not be practical.
Yigal
Rechtman, CPA, CFE, CITP, CISM
New York, N.Y.
The
authors respond:
The
writer expresses several valid concerns relative to the
use of fuzzy logic in assessing materiality. We agree completely
with the point:
Seasoned
auditors would know that material misstatements and possible
misstatements should be taken as a whole. At the conclusion
of their audit, auditors are required by professional
standards to assess the possible materiality of the aggregate
of possible misstatements. Accordingly, if several possible
misstatements are below the materiality threshold their
aggregate may still be considered a material misstatement.
[emphasis added]
In
fact, in his first paragraph the writer quotes a portion
of a sentence in our article: “The authors indicate
that ‘in practice, an auditor must make an oversimplified
binary decision’ about materiality.” The entire
sentence in the article actually reads:
In
practice, an auditor must make an oversimplified, binary
decision for each omission and misstatement, both individually
and in the aggregate: It is either material or
it is not. [emphasis added]
So
we most certainly acknowledge that seasoned auditors need
to assess materiality both for individual misstatements/omissions
and by aggregating all of the potential misstatements. Our
original manuscript included a comprehensive case study
that contrasted the classical system of assessing materiality
with the fuzzy logic approach. This case study, excluded
due to space constraints, included an example of a retail
company with a detailed set of financial statements and
four potential misstatements. The auditor was examining
a credit sales overstatement, allowance for bad-debts understatement,
inventory overstatement, and accrued interest understatement.
Each misstatement was assessed for materiality using two
quantitative considerations: 1) Did the amount of the misstatement
exceed planning materiality, and 2) Could it be precisely
measured. In addition, there were four qualitative considerations:
If the misstatement were corrected did it: 1) reduce earnings
per share below the consensus analyst earnings forecast;
2) change net income to a net loss; 3) reduce the current
ratio below the level required to be maintained to comply
with a loan covenant agreement; or 4) increase management
compensation. These misstatements were examined individually
and in aggregate. Based on the facts in this example, a
reasonable auditor would have likely concluded that the
understatement of the allowance for doubtful accounts might
be material because it could not be measured precisely,
and that the credit sales overstatement might be material
because it increased management compensation. The misstatements
were not likely to be considered material even when aggregated.
This contrasts with the auditor’s decision using fuzzy
logic, in which all of the misstatements would be considered
material based on their qualitative factors. So
the example illustrates that fuzzy logic techniques may
lead to the identification of material misstatements/omissions
when classical techniques indicate otherwise.
The
writer also points out that fuzzy logic may have limitations
because of the following:
Specifically,
our legal system may not be positioned to accept a level
of ambiguity about such matters. The question of materiality
is of import to auditors, who put their name out to the
public to attest that the users of financial statement
may rely on the assertions in the statement in all material
respects. In legal terms, the reliance on materiality
is fundamental to the degree of responsibility auditors
may take on their attestation. Modifying the definition
of materiality could have grave consequences to auditors
if it does not stand in court.
True,
auditors must be aware of possible litigation risk, and
thus any techniques they use in their audit, especially
in an area as important as materiality assessment, must
be substantiated. However, we do not see the use of fuzzy
logic in assessing materiality to be problematic in this
sense. We are suggesting the use of fuzzy logic to help
the auditor identify material misstatements/omissions that
might be assessed as immaterial using the classical approach.
If an auditor does consider something to be material, she
will most likely ask the client to correct the misstatement.
In fact, in SAB 99, the SEC recommends that the auditor
encourage the client to adjust even immaterial items.
We
are not suggesting in this article that an auditor who has
determined that an item is material using the classical
approach then follow fuzzy logic rules that consider it
immaterial. What is more realistic, and what we are
suggesting here, is that fuzzy logic rules can help the
auditor detect material items that under classical techniques
would be considered immaterial. Thus, we propose the use
of fuzzy logic to help reduce the auditor’s
risk, not increase it. If the auditor uses fuzzy logic and
finds something to be material that had previously considered
immaterial, the worst that could happen is that the auditor
may have to investigate further and do more work, or have
the client adjust even immaterial misstatements. These steps
would not increase the auditor’s litigation risk in
any way. Rather, fuzzy logic techniques help the auditor
be more conservative in the audit, thereby reducing audit
risk and hence litigation risk.
Finally,
the writer raises another valid concern, that fuzzy-logic
expert systems generally—
work
best with events that tend to repeat within a certain
domain of results. In these domains, expert systems can
be constructed around repeated trends and understanding
of the domain of possible outcomes. However,
financial statements and audits are anything but a domain
of limited outcomes; each engagement and each financial
statement has unique and dynamic characteristics and challenges.
Expert systems will be hard pressed to accommodate each
and every audit engagement with its unique environment,
period-to-period adjustable variables, and new variables.
Although in theory this can be accomplished, I am afraid
the cost would be substantial on a per-engagement basis.
We
completely agree that each audit engagement is unique, but
similar circumstances exist in other areas in which expert
systems can be useful. An expert system does not replace
expert judgment but rather captures criteria based on input
by real experts that can be standardized from case to case.
A physician, for example, may ask a standard set of questions
of a patient when diagnosing an illness, and thus a physician’s
input is needed to build an expert system to diagnose certain
diseases. Expert
systems are rarely used as substitutes for human judgment;
rather, they provide additional tools to aid human experts
in carrying out their tasks. An expert fuzzy-logic system
that can help the auditor assess materiality must be built
using input by expert auditors, and would allow the auditor
to enter certain unique criteria or validities that relate
specifically to the audit firm’s criteria or those
of the client.
In
summary, fuzzy-logic expert systems to assess materiality
are not intended to be used blindly by the auditor or to
replace traditional tools, but rather to be used in conjunction
with other tools to help improve the materiality assessment
process, primarily for the purpose of identifying material
items that might otherwise have been considered to be immaterial.
Rebecca
L. Rosner, PhD, CPA, CISA
Christie L. Comunale, PhD, CPA
Long Island University–C.W. Post Campus, Brookville,
N.Y.
Thomas R. Sexton, PhD
Stony Brook University, Stony Brook, N.Y.
Regarding
‘Functional Expense Reporting for Nonprofits’
I found
“Functional Expense Reporting for Nonprofits: The
Accounting Profession’s Next Scandal?” (August
2006) to be very well written and informative, the kind
I have come to expect from your journal. However, on the
practical application front, I have some problems with implementation
of one of their comments.
According
to the article, donated facilities and services are not
always properly reported. It goes on to state that “CPAs
should urge nonprofits to adopt staff timesheets and to
use them for functional-cost allocation.”
Staff
members at our nonprofit customers do that at this time;
however, a very large portion of the services are by unpaid
officers and directors, particularly for fundraising. Should
unpaid officers and directors now be required to submit
timesheets, and should a value be put upon them?
Philip
Beckett, CPA
Gloversville, N.Y.
The
authors respond:
Answering
this question well requires more-detailed information. Our
article recommends only that GAAP and IRS rules be followed.
If the services contributed by unpaid officers and directors
meet one of the two tests of SFAS 116, paragraph 9, they
should be recognized as revenue in financial statements,
and some sort of timesheet system for these volunteers would
make sense. The tests are if the services “create
or enhance nonfinancial assets” or “require
specialized skills, are provided by individuals possessing
those skills, and would typically need to be purchased if
not provided by donation.” Board members making phone
calls to ask for money or organizing a fundraising dinner
would not meet these tests. A board member who is a lawyer
providing pro bono legal services would.
If
the services do not meet the tests of SFAS 116, paragraph
9, then, according to paragraph 10, “Entities are
encouraged to disclose the fair value of contributed services
received but not recognized as revenue if that is practicable.”
This encouragement is not a requirement.
Under
IRS rules, all contributed services are excluded from both
revenue and expense; however, our article details the places
on Form 990 where the value of contributed services is to
be disclosed, to the extent the organization has a reasonable
basis and documentation to support the amount reported.
This can include amounts measured under either paragraph
9 or 10; therefore, the voluntarily disclosed amount may
include volunteer services not recognized as revenue under
GAAP.
In an ideal world, it would be “practicable”
to measure and disclose the value of all contributed services.
In the meantime, we would be satisfied if current GAAP and
IRS requirements were met.
Kennard
Wing, CMA
Kennard T. Wing & Co., Havertown, Pa.
Teresa Gordon, PhD, CPA
University of Idaho, Moscow, Idaho
Mark Hager, PhD
Center
for Community and Business Research, Institute for Economic
Development, University of Texas at San Antonio
Thomas Pollak, JD
National Center for Charitable Statistics, the Urban Institute,
Washington, D.C.
Patrick Rooney, PhD
Center on Philanthropy, Indiana University, and Indiana
University–Purdue University, Indianapolis.
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